Equitec Group, LLC
February 14, 2003
Mr. Jonathan Katz
Re: Filing of Proposed Rule Change by the Boston Stock Exchange, Inc. Establishing Trading Rules of the Boston Options Exchange Facility; File No., SR-BSE-2002-15
Dear Mr. Katz,
On behalf of Equitec Group, LLC and its affiliated firms ("Equitec") we are pleased to offer comments on the above-captioned filing of a proposed rule change by the Boston Stock Exchange, Inc. establishing Rules for the Boston Options Exchange ("BOX") Facility (the "Proposed Rule Change"). Equitec is a liquidity provider that includes, within the Equitec family of firms, several broker dealers that are members of the five existing options exchanges and function as market makers and specialists on those exchanges.
"The primary mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors and maintain the integrity of the securities markets."
These words, taken from the Introduction section of the SEC website, have embedded within two principle concepts: protection of investors and market integrity. In the last five years there have been several developments in market structure that have proven to be inconsistent with those goals. Specifically, payment for order flow, internalization, penny increments in stocks and market fragmentation have resulted in conflicts of interest, appearance of impropriety, increased volatility and long term impairment of liquidity pools. The impending creation of the BOX as a sixth equity options exchange venue under the rules as proposed is yet another step towards destabilization of domestic securities markets. What is worse is that this development is coming at a tenuous economic and political time when the national and international investment community must believe in the integrity and strength of the world's financial center.
The proposed BOX facility is not completely without merit. It would appear that, to the extent discernible from the filing, the proposed electronic venue could be a far more open and inexpensive place for liquidity providers than the existing screen-based alternatives. However, the Commission cannot evaluate this proposed model as if it will operate in a vacuum. The existence of five other exchanges, and how the BOX will interact with them, dramatically affects how the entire industry will operate for the foreseeable future. As we discuss more fully below, order flow providers will utilize the PIP auction procedure to internalize the favorable orders on the BOX. Unfavorable orders will "make their way" to another exchange. Orders will be subject to conflicting routing criteria that will further diminish the integrity of our system. Under this proposed plan customers will be disadvantaged.
Don't Create a Preferencing System
Under Section 6 (b)(5) of the Securities Exchange Act of 1934, "a registered national securities exchange must have rules that are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and , in general, to protect investors and the public interest." (SEC Release No. 34-42825, May 25, 2000, emphasis added). It is our view that the proposed BOX rules do not meet this requirement.
The "auction" process the BOX is proposing in the PIP auction procedure is nothing more than a veiled attempt to siphon the most desirable orders from the true population of marketmakers who provide liquidity at all times, not just when it appears the most profitable. Penny auctions are merely the vehicle that the BOX sponsors have identified as the way to achieve the objective of internalizing orders. The proposed BOX exchange has been conceived to facilitate trading of the desirable order (i.e. an order that originates from an unknowledgeable public customer, closes open interest, has significant edge to mid-market, enables the trade of another order, reduces risk, etc...). Very little attention is being paid to the less desirable order, the type of order that nobody wants (i.e. the professional order, the order that increases open interest, the order that trades for little or no spread, and/or increases risk). Servicing the first type of order is easy, as there are a plethora of traders who want to participate in the transaction. There is no need to assemble an additional pool of liquidity to service this order. It is the latter order, the undesirable order, that is the very reason that exchanges and marketmakers exist. It is the desirable order that permits more efficient pricing of the undesirable order.
The customers that place the undesirable orders are unquestionably disadvantaged under the BOX's new proposed exchange paradigm. These customers' orders will not be executed on the BOX, but will be routed to another exchange where they will be priced less effectively due to the inefficiencies that this preferencing system creates. The result will be an exchange environment where those firms that wish to trade against their customers' orders and are only willing to commit capital when it appears to be most profitable, will be disadvantaging every other customer and liquidity provider in the marketplace. This practice increases the cost of serving the remaining customer base, decreases the "true" liquidity providers' ability to service the remaining order flow and serves to further destabilize and degrade the integrity of U.S. securities markets.
The Internalization Problem
Internalization has long been a problem in the exchange environment. The practice of allowing an order flow provider to trade as principal against its own customer compromises the integrity of the option industry at a time when the global investment community is reeling from research scandals, Enron, Arthur Andersen and similar failures. We believe the Commission should be looking for ways to bolster confidence in the markets, rather than approving an exchange model that creates the opportunity for abusive and anti-competitive practices. Certain order flow providers will "show up" on the BOX with a penny price improvement to internalize a "good" order that is in their pipeline, but will bear no obligation with respect to any other orders. Creation of this facility will move the options industry towards a pre-arranged crossing model similar to that which has developed on EUREX. In Europe, the sought-after trades are often negotiated on the phone prior to "meeting" electronically on the screen without having been adequately exposed to the marketplace
The Commission's mandate to protect investors is not furthered by such a facility. The goals set forth in the SEC mission statement and the Release cited above are achieved by promoting a marketplace characterized by unquestionable integrity and by instilling in the investor the confidence that when he or she wishes to liquidate his or her position, there will be adequate competition among liquidity providers that will enable fair price discovery. The integrity of the marketplace is jeopardized when an agent has a profit incentive on the opposing side of his customer's trade.
Long Term Impact on Markets
Liquidity providers are already struggling to survive in the existing exchange environment. We must compete with brokers and order flow providers who leverage the existence of another exchange to bully trading crowds into facilitating the internalization of orders. The proposed BOX rules create a venue in which an even greater portion of the desirable order flow can be anonymously crossed, compromising the remaining marketmakers' ability to price the orders that these firms wish to avoid. A marketmaker is obligated to provide fair and orderly markets via continuous two-sided quotes during all market condition to all market participants. Implementation of the BOX rules will severely impair the ability of these marketmakers to perform this vital function.
The U.S. exchange marketplace is becoming more automated and screen-based. The exchange community recognizes the benefits and is spending hundreds of millions to address the need. There are a number of laudable initiatives proposed within the BOX model. However, as mentioned above, the BOX model may lead to developments similar to what is taking place in European markets. The Commission should not confuse the European environment, with its different market structure and liquidity requirements, with that of the U.S. Most countries have only one options exchange, whereas we are now contemplating a sixth. In these countries option orders are exposed in one central marketplace to the entire population of marketmakers. There is no other destination in which the less desirable order is traded and therefore no routing determinations are made. In the United States, by contrast, creation of the BOX as proposed would add the desirability of the order to a menu of questionable routing criteria that currently includes payment amount, crossing percentage and ability to move quotes to a desired price. We believe that routing of orders based on such criteria is detrimental to the integrity of our markets.
Our market structure is currently floundering in untested waters as proven liquidity providers are delisting stocks by the hundreds, reducing payroll and cutting overhead. There are no longer sufficient margins in securities markets to support any excess capacity, yet it is this capacity that allows our system to function fluidly during the unpredictable periods of severe demand. Further stressing the system almost certainly will exacerbate the next demanding liquidity event in the U.S.
We urge the Commission to consider the fact that the BOX will not operate in a vacuum, but within the framework of an existing exchange environment. Given that, we believe that the proposed BOX rules create a preferencing system with the primary objective being the internalization of order flow. For the above reasons we urge that the Commission not approve the proposed BOX rules.
Thank you for the opportunity to comment on this filing.